Research Topics

Publications on Financial regulation

Edited by Rainer Kattel, Jan Kregel, and Mario Tonveronachi

Have past and more recent regulatory changes contributed to increased financial stability in the European Union (EU), or have they improved the efficiency of individual banks and national financial systems within the EU? Edited by Rainer Kattel, Tallinn University of Technology, Director of Research Jan Kregel, and Mario Tonveronachi, University of Siena, this volume offers a comparative overview of how financial regulations have evolved in various European countries since the introduction of the single European market in 1986. The collection includes a number of country studies (France, Germany, Italy, Spain, Estonia, Hungary, Slovenia) that analyze the domestic financial regulatory structure at the beginning of the period, how the EU directives have been introduced into domestic legislation, and their impact on the financial structure of the economy. Other contributions examine regulatory changes in the UK and Nordic countries, and in postcrisis America.

This monograph is part of the Levy Institute’s Research and Policy Dialogue Project on Improving Governance of the Government Safety Net in Financial Crisis, a two-year project funded by the Ford Foundation.

This is the fourth in a series of reports summarizing the findings of the Research and Policy Dialogue Project on Improving Governance of the Government Safety Net in Financial Crisis, directed by Senior Scholar L. Randall Wray. This project explores alternative methods of providing a government safety net in times of crisis. In the global financial crisis that began in 2007, the United States used two primary responses: a stimulus package approved and budgeted by Congress, and a complex and unprecedented response by the Federal Reserve. The project examines the benefits and drawbacks of each method, focusing on questions of accountability, democratic governance and transparency, and mission consistency.

The project has also explored the possibility of reform that might place more responsibility for provision of a safety net on Congress, with a smaller role to be played by the Fed, enhancing accountability while allowing the Fed to focus more closely on its proper mission. Given the rise of shadow banking—a financial system that operates largely outside the reach of bank regulators and supervisors—the Fed faces a complicated problem. It might be necessary to reform finance, through downsizing and a return to what Hyman Minsky called “prudent banking,” before we can reform the Fed.

This report describes the overall scope of the project and summarizes key findings from the three previous reports, as well as additional research undertaken in 2014.

Policy Challenges for Central Banks

Central banks responded with exceptional liquidity support during the financial crisis to prevent a systemic meltdown. They broadened their tool kit and extended liquidity support to nonbanks and key financial markets. Many want central banks to embrace this expanded role as “market maker of last resort” going forward. This would provide a liquidity backstop for systemically important markets and the shadow banking system that is deeply integrated with these markets. But how much liquidity support can central banks provide to the shadow banking system without risking their balance sheets? I discuss the expanding role of the shadow banking sector and the key drivers behind its growing importance. There are close parallels between the growth of shadow banking before the recent financial crisis and earlier financial crises, with rapid growth in near monies as a common feature. This ebb and flow of shadow-banking-type liabilities are indeed an ingrained part of our advanced financial system. We need to reflect and consider whether official sector liquidity should be mobilized to stem a future breakdown in private shadow banking markets. Central banks should be especially concerned about providing liquidity support to financial markets without any form of structural reform. It would indeed be ironic if central banks were to declare victory in the fight against too-big-to-fail institutions, just to end up bankrolling too-big-to-fail financial markets.

What a Hedge Gone Awry at JPMorgan Chase Tells Us about What's Wrong with Dodd-Frank

What can we learn from JPMorgan Chase’s recent self-proclaimed “stupidity” in attempting to hedge the bank’s global risk position? Clearly, the description of the bank’s trading as “sloppy” and reflecting ”bad judgment” was designed to prevent the press reports of large losses from being used to justify the introduction of more stringent regulation of large, multifunction financial institutions. But the lessons to be drawn are not to be found in the specifics of the hedges that were put on to protect the bank from an anticipated decline in the value of its corporate bond holdings, or in any of its other global portfolio hedging activities. The first lesson is this: despite their acumen in avoiding the worst excesses of the subprime crisis, the bank’s top managers did not have a good idea of its exposure, which serves as evidence that the bank was “too big to manage.” And if it was too big to manage, it was clearly too big to regulate effectively.

Though the economy appears to be gradually gaining momentum, broad measures indicate that 14.5 percent of the US labor force is unemployed or underemployed, not much below the 16.2 percent rate reached a full year ago. In this new report in our Strategic Analysis series, we first discuss several slow-moving factors that make it difficult to achieve a full and sustainable economic recovery: the gradual redistribution of income toward the wealthiest 1 percent of households; a failure to fully stabilize and reregulate finance; serious fiscal troubles for state and local governments; and detritus from the financial crisis that remains on household and corporate balance sheets. These factors contribute to a situation in which employment has not risen fast enough since the (supposed) end of the recession to significantly increase the employment-population ratio. Meanwhile, public investment at all levels of government fell from roughly 3.7 percent of GDP in 2008 to 3.2 percent in the fourth quarter of 2011, helping to explain the weak economic picture.

For this report, we use the Levy Institute macro model to simulate the economy under the following three scenarios: (1) a private borrowing scenario, in which we find the appropriate amount of private sector net borrowing/lending to achieve the path of employment growth projected under current policies by the Congressional Budget Office (CBO), in a report characterized by excessive optimism and a bias toward deficit reduction; (2) a more plausible scenario, in which we assume that the federal government extends certain key tax cuts and that household borrowing increases at a more reasonable rate than in the previous scenario; and (3) a fiscal stimulus scenario, in which we simulate the effects of a fully “paid for” 1 percent increase in government investment.

The results show the importance of debt accumulation as a consideration in macro policymaking. The first scenario reproduces the CBO’s relatively optimistic employment projections, but our results indicate that this private-sector-led growth scenario quickly brings household and business debt to new all-time highs as percentages of GDP. We note that the CBO makes its projections using an orthodox model with several common, but fundamental, flaws. This makes possible the agency’s result that current policies will reduce the unemployment rate without a run-up in the private sector’s debt—“business as usual,” in the words of our report’s title.

The policies weighed in the second scenario do not perform much better, despite a looser fiscal stance. Finally, our third scenario illustrates that a small, tax-financed increase in government investment could lower the unemployment rate significantly—by about one-half of 1 percent. A stimulus package of this size might be within the realm of political possibility at this juncture. However, our results lead us to surmise that it would take a much more substantial fiscal stimulus to reduce unemployment to a level that most policymakers would regard as acceptable.

This monograph is part of the Institute’s research program on Financial Instability and the Reregulation of Financial Institutions and Markets, funded by the Ford Foundation. Its purpose is to investigate the causes and development of the recent financial crisis from the point of view of the late financial economist and Levy Distinguished Scholar Hyman Minsky, and to propose “a thorough, integrated approach to our economic problems.”

The monograph draws on Minsky’s work on financial regulation to assess the efficacy of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, enacted in response to the 2008 subprime crisis and subsequent deep recession. Some two years after its adoption, the implementation of Dodd-Frank is still far from complete. And despite the fact that a principal objective of this legislation was to remove the threat of taxpayer bailouts for banks deemed “too big to fail,” the financial system is now more concentrated than ever and the largest banks even larger. As economic recovery seems somewhat more assured and most financial institutions have regrouped sufficiently to repay the governmental support they received, the specific rules and regulations required to make Dodd-Frank operational are facing increasing resistance from both the financial services industry and from within the US judicial system.

This suggests that the Dodd-Frank legislation may be too extensive, too complicated, and too concerned with eliminating past abuses to ever be fully implemented, much less met with compliance. Indeed, it has been called a veritable paradise for regulatory arbitrage. The result has been a call for a more fundamental review of the extant financial legislation, with some suggesting a return to a regulatory framework closer to Glass-Steagall’s separation of institutions by function—a cornerstone of Minsky’s extensive work on regulation in the 1990s. For Minsky, the goal of any systemic reform was to ensure that the basic objectives of the financial system—to support the capital development of the economy and to provide a safe and secure payments system—were met. Whether the Dodd-Frank Act can fulfill this aspect of its brief remains an open question.

Henry Simons’s 1936 article “Rules versus Authorities in Monetary Policy” is a classical reference in the literature on central bank independence and rule-based policy. A closer reading of the article reveals a more nuanced policy prescription, with significant emphasis on the need to control short-term borrowing; bank credit is seen as highly unstable, and price level controls, in Simons’s view, are not be possible without limiting banks’ ability to create money by extending loans. These elements of Simons’s theory of money form the basis for Hyman P. Minsky’s financial instability hypothesis. This should not come as a surprise, as Simons was Minsky’s teacher at the University of Chicago in the late 1930s. I review the similarities between their theories of financial instability and the relevance of their work for the current discussion of macroprudential tools and the conduct of monetary policy. According to Minsky and Simons, control of finance is a prerequisite for successful monetary policy and economic stabilization.

How to Achieve a Better Balance between Global and Official Liquidity

Global liquidity provision is highly procyclical. The recent financial crisis has resulted in a flight to safety, with severe strains in key funding markets leading central banks to employ highly unconventional policies to avoid a systemic meltdown. Bagehot’s advice to “lend freely at high rates against good collateral” has been stretched to the limit in order to meet the liquidity needs of dysfunctional financial markets. As the eligibility criteria for central bank borrowing have been tweaked, it is legitimate to ask, How elastic should the supply of central bank currency be?

Even when the central bank has the ability to create abundant official liquidity, there should be some limits to its support for the financial sector. Traditionally, the misuse of the fiat money privilege has been limited by self-imposed rules that central bank loans must be fully backed by gold or collateralized in some other way. But since the onset of the crisis, we have seen how this constraint has been relaxed to accommodate the demand for market support. My suggestion is that there has to be some upper limit, and that we should work hard to find guidelines and policies that can limit the need for central bank liquidity support in future crises.

In this paper, I review the recent expansion of central bank liquidity support during the crisis, before discussing the collateral polices related to central banks’ lender-of-last-resort and market-maker-of-last-resort policies and their rationale. I then examine the relationship between the central bank and the treasury, and the potential threat to central bank independence if they venture into too much risky balance sheet expansion. A discussion about the exceptional growth of the shadow banking system follows. I introduce the concept of “liquidity illusion” to describe the fragility upon which much of the sector is based, and note that market growth has been based largely on a “fair-weather” view that central banks will support the market on rainy days. I argue that we need a better theoretical framework to understand the growth in the shadow banking system and the role of central banks in providing liquidity in a crisis.

Recently, the concept of “endogenous finance” has been used to explain the strong procyclical tendencies of the global financial system. I show that this concept was central to Hyman P. Minsky’s theory of financial instability, and suggest that his insights should be integrated into the ongoing search for a better theoretical framework for understanding the growth of the shadow banking system and how we can limit official liquidity support for this system. I end the paper with a summary and a discussion of some of the policy issues. I note that the Basel III “package” will hopefully reduce the need for central bank liquidity support in the future, but suggest that further structural reforms of the financial sector are needed to ease the tension between freewheeling private credit expansion and the limited ability or willingness of central banks to provide unlimited official liquidity support in a future crisis.

Motives, Countermeasures, and the Dodd-Frank Response

Government forbearance, support, and bailouts of banks and other financial institutions deemed “too big to fail” (TBTF) are widely recognized as encouraging large companies to take excessive risk, placing smaller ones at a competitive disadvantage and influencing banks in general to grow inefficiently to a “protected” size and complexity. During periods of financial stress, with bailouts under way, government officials have promised “never again.” During periods of financial stability and economic growth, they have sanctioned large-bank growth by merger and ignored the ongoing competitive imbalance.

Repeated efforts to do away with TBTF practices over the last several decades have been unsuccessful. Congress has typically found the underlying problem to be inadequate regulation and/or supervision that has permitted important financial companies to undertake excessive risk. It has responded by strengthening regulation and supervision. Others have located the underlying problem in inadequate regulators, suggesting the need for modifying the incentives that motivate their behavior. A third explanation is that TBTF practices reflect the government’s perception that large financial firms serve a public interest—they constitute a “national resource” to be preserved. In this case, a structural solution would be necessary. Breakups of the largest financial firms would distribute the “public interest” among a larger group than the handful that currently hold a disproportionate concentration of financial resources.

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 constitutes the most recent effort to eliminate TBTF practices. Its principal focus is on the extension and augmentation of regulation and supervision, which it envisions as preventing excessive risk taking by large financial companies; Congress has again found the cause for TBTF practices in the inadequacy of regulation and supervision. There is no indication that Congress has given any credence to the contention that regulatory motivations have been at fault. Finally, Dodd-Frank eschews a structural solution, leaving the largest financial companies intact and bank regulatory agencies still with extensive discretion in passing on large bank mergers. As a result, the elimination of TBTF will remain problematic for years to come.

Currency market intervention–cum–reserve accumulation has emerged as the favored “self-insurance” strategy in recipient countries of excessive private capital inflows. This paper argues that capital account management represents a less costly alternative line of defense deserving renewed consideration, especially in the absence of fundamental reform of the global monetary and financial order. Mainstream arguments in favor of financial globalization are found unconvincing; any indirect benefits allegedly obtainable through hot money inflows are equally obtainable without actually tolerating such inflows. The paper investigates the experiences of Brazil, Russia, India, and China (the BRICs) in the global crisis and subsequent recovery, focusing on their respective policies regarding capital flows.

Will Dodd-Frank Prevent "It" from Happening Again?
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This monograph is part of the Institute's ongoing research program on Financial Instability and the Reregulation of Financial Institutions and Markets, funded by the Ford Foundation. This program's purpose is to investigate the causes and development of the recent financial crisis from the point of view of the late financial economist and Levy Distinguished Scholar Hyman P. Minsky. The monograph draws on Minsky's extensive work on regulation in order to review and analyze the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, enacted in response to the crisis in the US subprime mortgage market, and to assess whether this new regulatory structure will prevent "It"—a debt deflation on the order of the Great Depression—from happening again. It seeks to assess the extent to which the Act will be capable of identifying and responding to the endogenous generation of financial fragility that Minsky believed to be the root cause of financial instability, building on the views expressed in his published work, his official testimony, and his unfinished draft manuscript on the subject. Whether the Dodd-Frank Act will fulfill its brief—in part, "to promote the financial stability in the United States by improving accountability and transparency in the financial system, to end 'too big to fail,' to protect the American taxpayer by ending bailouts, [and] to protect consumers from abusive financial services practices"—is an open question. As Minsky wrote in his landmark 1986 book Stabilizing an Unstable Economy, "A new era of reform cannot be simply a series of piecemeal changes. Rather, a thorough, integrated approach to our economic problems must be developed." This has been one of the organizing principles of our project.

Scott Fullwiler and Senior Scholar L. Randall Wray review the roles of the Federal Reserve and the Treasury in the context of quantitative easing, and find that the financial crisis has highlighted the limited oversight of Congress and the limited transparency of the Fed. And since a Fed promise is ultimately a Treasury promise that carries the full faith and credit of the US government, the question is whether the Fed should be able to commit the public purse in times of national crisis.

Financial Fragility Indexes

With the Great Recession and the regulatory reform that followed, the search for reliable means to capture systemic risk and to detect macrofinancial problems has become a central concern. In the United States, this concern has been institutionalized through the Financial Stability Oversight Council, which has been put in charge of detecting threats to the financial stability of the nation. Based on Hyman Minsky’s financial instability hypothesis, the paper develops macroeconomic indexes for three major economic sectors. The index provides a means to detect the speed with which financial fragility accrues, and its duration; and serves as a complement to the microprudential policies of regulators and supervisors. The paper notably shows, notably, that periods of economic stability during which default rates are low, profitability is high, and net worth is accumulating are fertile grounds for the growth of financial fragility.

Some Postrecession Regulatory Implications

Over the past 40 years, regulatory reforms have been undertaken on the assumption that markets are efficient and self-corrective, crises are random events that are unpreventable, the purpose of an economic system is to grow, and economic growth necessarily improves well-being. This narrow framework of discussion has important implications for what is expected from financial regulation, and for its implementation. Indeed, the goal becomes developing a regulatory structure that minimizes the impact on economic growth while also providing high-enough buffers against shocks. In addition, given the overarching importance of economic growth, economic variables like profits, net worth, and low default rates have been core indicators of the financial health of banking institutions.

This paper argues that the framework within which financial reforms have been discussed is not appropriate to promoting financial stability. Improving capital and liquidity buffers will not advance economic stability, and measures of profitability and delinquency are of limited use to detect problems early. The paper lays out an alternative regulatory framework and proposes a fundamental shift in the way financial regulation is performed, similar to what occurred after the Great Depression. It is argued that crises are not random, and that their magnitude can be greatly limited by specific pro-active policies. These policies would focus on understanding what Ponzi finance is, making a difference between collateral-based and income-based Ponzi finance, detecting Ponzi finance, managing financial innovations, decreasing competitions in the banking industry, ending too-big-to-fail, and deemphasizing economic growth as the overarching goal of an economic system. This fundamental change in regulatory and supervisory practices would lead to very different ways in which to check the health of our financial institutions while promoting a more sustainable economic system from both a financial and a socio-ecological point of view.

The Financial Trilemma and the Wall Street Complex

This would seem an opportune moment to reshape banking systems in the Americas. But any effort to rethink and improve banking must acknowledge three major barriers. The first is a crisis of vision: there has been too little consideration of what kind of banking system would work best for national economies in the Americas. The other two constraints are structural. Banking systems in Mexico and the rest of Latin America face a financial regulation trilemma, the logic and implications of which are similar to those of smaller nations’ macroeconomic policy trilemma. The ability of these nations to impose rules that would pull banking systems in the direction of being more socially productive and economically functional is constrained both by regional economic compacts (in the case of Mexico, NAFTA) and by having a large share of the domestic banking market operated by multinational banks.

For the United States, the structural problem involves the huge divide between Wall Street megabanks and the remainder of the US banking system. The ambitions, modes of operation, and economic effects of these two different elements of US banking are quite different. The success, if not survival, of one element depends on the creation of a regulatory atmosphere and set of enabling federal government subsidies or supports that is inconsistent with the success, or survival, of the other element.

Motives, Countermeasures, and Prospects

Regulatory forbearance and government financial support for the largest US financial companies during the crisis of 2007–09 highlighted a "too big to fail" problem that has existed for decades. As in the past, effects on competition and moral hazard were seen as outweighed by the threat of failures that would undermine the financial system and the economy. As in the past, current legislative reforms promise to prevent a reoccurrence.

This paper proceeds on the view that a better understanding of why too-big-to-fail policies have persisted will provide a stronger basis for developing effective reforms. After a review of experience in the United States over the last 40 years, it considers a number of possible motives. The explicit rationale of regulatory authorities has been to stem a systemic threat to the financial system and the economy resulting from interconnections and contagion, and/or to assure the continuation of financial services in particular localities or regions. It has been contended, however, that such threats have been exaggerated, and that forbearance and bailouts have been motivated by the "career interests" of regulators. Finally, it has been suggested that existing large financial firms are preserved because they serve a public interest independent of the systemic threat of failure they pose—they constitute a "national resource."

Each of these motives indicates a different type of reform necessary to contain too-big-to-fail policies. They are not, however, mutually exclusive, and may all be operative simultaneously. Concerns about the stability of the financial system dominate current legislative proposals; these would strengthen supervision and regulation. Other kinds of reform, including limits on regulatory discretion, would be needed to contain "career interest" motivations. If, however, existing financial companies are viewed as serving a unique public purpose, then improved supervision and regulation would not effectively preclude bailouts should a large financial company be on the brink of failure. Nor would limits on discretion be binding.

To address this motivation, a structural solution is necessary. Breakups through divestiture, perhaps encompassing specific lines of activity, would distribute the "public interest" among a larger group of companies than the handful that currently hold a disproportionate and growing concentration of financial resources. The result would be that no one company, or even a few, would appear to be irreplaceable. Neither economies of scale nor scope appear to offset the advantages of size reduction for the largest financial companies. At a minimum, bank merger policy that has, over the last several decades, facilitated their growth should be reformed so as to contain their continued absolute and relative growth. An appendix to the paper provides a review of bank merger policy and proposals for revision.

The current financial crisis has been characterized as a “Minsky” moment, and as such provides the conditions required for a reregulation of the financial system similar to that of the New Deal banking reforms of the 1930s. However, Minsky’s theory was not one that dealt in moments but rather in systemic, structural changes in the operations of financial institutions. Therefore, the framework for reregulation must start with an understanding of the longer-term systemic changes that took place between the New Deal reforms and their formal repeal under the 1999 Financial Services Modernization Act. This paper attempts to identify some of those changes and their sources. In particular, it notes that the New Deal reforms were eroded by an internal process in which commercial banks that were given a monopoly position in deposit taking sought to remove those protections because unregulated banks were able to provide substitute instruments that were more efficient and unregulated but unavailable to regulated banks, since they involved securities market activities that would eventually be recognized as securitization. Regulators and the courts contributed to this process by progressively ruling that these activities were related to the regulated activities of the commercial banks, allowing them to reclaim securities market activities that had been precluded in the New Deal legislation. The 1999 Act simply made official the de facto repeal of the 1930s protections. Any attempt to provide reregulation of the system will thus require safeguards to ensure that this internal process of deregulation is not repeated.

The extension of the subprime mortgage crisis to a global financial meltdown led to calls for fundamental reregulation of the United States financial system. However, that reregulation has been slow in implementation and the proposals under discussion are far from fundamental. One explanation for this delay is the fact that many of the difficulties stemmed not from lack of regulation but from a failure to fully implement existing regulations. At the same time, the crisis evolved in stages, interspersed by what appeared to be the system’s return to normalcy. This evolution can be defined in terms of three stages (regulation and supervision, securitization, and a run on investment banks), each stage associated with a particular failure of regulatory supervision. It thus became possible to argue at each stage that all that was necessary was the appropriate application of existing regulations, and that nothing more needed to be done. This scenario progressed until the collapse of Lehman Brothers brought about a full-scale recession and attention turned to support of the real economy and employment, leaving the need for fundamental financial regulation in the background.

Summary Tables

This four-part study is a critical analysis of several reports dealing with the reform of the financial system in the United States. The study uses Minsky’s framework of analysis and focuses on the implications of Ponzi finance for regulatory and supervisory policies. The main conclusion of the study is that, while all reports make some valuable suggestions, they fail to deal with the socioeconomic dynamics that emerge during long periods of economic stability. As a consequence, it is highly doubtful that the principal suggestions contained in the reports will provide any applicable means to limit the worsening of financial fragility over periods of economic stability. The study also concludes that any meaningful systemic and prudential regulatory changes should focus on the analysis of expected and actual cash flows (sources and stability) rather than capital equity, and on preventing the emergence of Ponzi processes. The latter tend to emerge over long periods of economic stability and are not necessarily engineered by crooks. On the contrary, the pursuit of economic growth may involve the extensive use of Ponzi financial processes in legal economic activities. The study argues that some Ponzi processes—more precisely, pyramid Ponzi processes—should not be allowed to proceed, no matter how severe the immediate impact on economic growth, standards of living, or competitiveness. This is so because pyramid Ponzi processes always collapse, regardless how efficient financial markets are, how well informed and well behaved individuals are, or whether there is a “bubble” or not. The longer the process is allowed to proceed, the more destructive it becomes. Pyramid Ponzi processes cannot be risk-managed or buffered against; if economic growth is to be based on a solid financial foundation, these processes cannot be allowed to continue. Finally, a supervisory and regulatory process focused on detecting Ponzi processes would be much more flexible and adaptive, since it would not be preoccupied with either functional or product limits, or with arbitrary ratios of “prudence.” Rather, it would oversee all financial institutions and all products, no matter how new or marginal they might be.

G30, OECD, GAO, ICMBS Reports

This four-part study is a critical analysis of several reports dealing with the reform of the financial system in the United States. The study uses Minsky’s framework of analysis and focuses on the implications of Ponzi finance for regulatory and supervisory policies. The main conclusion of the study is that, while all reports make some valuable suggestions, they fail to deal with the socioeconomic dynamics that emerge during long periods of economic stability. As a consequence, it is highly doubtful that the principal suggestions contained in the reports will provide any applicable means to limit the worsening of financial fragility over periods of economic stability. The study also concludes that any meaningful systemic and prudential regulatory changes should focus on the analysis of expected and actual cash flows (sources and stability) rather than capital equity, and on preventing the emergence of Ponzi processes. The latter tend to emerge over long periods of economic stability and are not necessarily engineered by crooks. On the contrary, the pursuit of economic growth may involve the extensive use of Ponzi financial processes in legal economic activities. The study argues that some Ponzi processes—more precisely, pyramid Ponzi processes—should not be allowed to proceed, no matter how severe the immediate impact on economic growth, standards of living, or competitiveness. This is so because pyramid Ponzi processes always collapse, regardless how efficient financial markets are, how well informed and well behaved individuals are, or whether there is a “bubble” or not. The longer the process is allowed to proceed, the more destructive it becomes. Pyramid Ponzi processes cannot be risk-managed or buffered against; if economic growth is to be based on a solid financial foundation, these processes cannot be allowed to continue. Finally, a supervisory and regulatory process focused on detecting Ponzi processes would be much more flexible and adaptive, since it would not be preoccupied with either functional or product limits, or with arbitrary ratios of “prudence.” Rather, it would oversee all financial institutions and all products, no matter how new or marginal they might be.

Treasury, CRMPG Reports, Financial Stability Forum

This four-part study is a critical analysis of several reports dealing with the reform of the financial system in the United States. The study uses Minsky’s framework of analysis and focuses on the implications of Ponzi finance for regulatory and supervisory policies. The main conclusion of the study is that, while all reports make some valuable suggestions, they fail to deal with the socioeconomic dynamics that emerge during long periods of economic stability. As a consequence, it is highly doubtful that the principal suggestions contained in the reports will provide any applicable means to limit the worsening of financial fragility over periods of economic stability. The study also concludes that any meaningful systemic and prudential regulatory changes should focus on the analysis of expected and actual cash flows (sources and stability) rather than capital equity, and on preventing the emergence of Ponzi processes. The latter tend to emerge over long periods of economic stability and are not necessarily engineered by crooks. On the contrary, the pursuit of economic growth may involve the extensive use of Ponzi financial processes in legal economic activities. The study argues that some Ponzi processes—more precisely, pyramid Ponzi processes—should not be allowed to proceed, no matter how severe the immediate impact on economic growth, standards of living, or competitiveness. This is so because pyramid Ponzi processes always collapse, regardless how efficient financial markets are, how well informed and well behaved individuals are, or whether there is a “bubble” or not. The longer the process is allowed to proceed, the more destructive it becomes. Pyramid Ponzi processes cannot be risk-managed or buffered against; if economic growth is to be based on a solid financial foundation, these processes cannot be allowed to continue. Finally, a supervisory and regulatory process focused on detecting Ponzi processes would be much more flexible and adaptive, since it would not be preoccupied with either functional or product limits, or with arbitrary ratios of “prudence.” Rather, it would oversee all financial institutions and all products, no matter how new or marginal they might be.

Key Concepts and Main Points

This four-part study is a critical analysis of several reports dealing with the reform of the financial system in the United States. The study uses Minsky’s framework of analysis and focuses on the implications of Ponzi finance for regulatory and supervisory policies. The main conclusion of the study is that, while all reports make some valuable suggestions, they fail to deal with the socioeconomic dynamics that emerge during long periods of economic stability. As a consequence, it is highly doubtful that the principal suggestions contained in the reports will provide any applicable means to limit the worsening of financial fragility over periods of economic stability. The study also concludes that any meaningful systemic and prudential regulatory changes should focus on the analysis of expected and actual cash flows (sources and stability) rather than capital equity, and on preventing the emergence of Ponzi processes. The latter tend to emerge over long periods of economic stability and are not necessarily engineered by crooks. On the contrary, the pursuit of economic growth may involve the extensive use of Ponzi financial processes in legal economic activities. The study argues that some Ponzi processes—more precisely, pyramid Ponzi processes—should not be allowed to proceed, no matter how severe the immediate impact on economic growth, standards of living, or competitiveness. This is so because pyramid Ponzi processes always collapse, regardless how efficient financial markets are, how well informed and well behaved individuals are, or whether there is a “bubble” or not. The longer the process is allowed to proceed, the more destructive it becomes. Pyramid Ponzi processes cannot be risk-managed or buffered against; if economic growth is to be based on a solid financial foundation, these processes cannot be allowed to continue. Finally, a supervisory and regulatory process focused on detecting Ponzi processes would be much more flexible and adaptive, since it would not be preoccupied with either functional or product limits, or with arbitrary ratios of “prudence.” Rather, it would oversee all financial institutions and all products, no matter how new or marginal they might be.

Deregulation, the Financial Crisis, and Policy Implications

This study analyzes the trends in the financial sector over the past 30 years, and argues that unsupervised financial innovations and lenient government regulation are at the root of the current financial crisis and recession. Combined with a long period of economic expansion during which default rates were stable and low, deregulation and unsupervised financial innovations generated incentives to make risky financial decisions. Those decisions were taken because it was the only way for financial institutions to maintain market share and profitability. Thus, rather than putting the blame on individuals, this paper places it on an economic setup that requires the growing use of Ponzi processes during enduring economic expansion, and on a regulatory system that is unwilling to recognize (on the contrary, it contributes to) the intrinsic instability of market mechanisms. Subprime lending, greed, and speculation are merely aspects of the larger mechanisms at work.

It is argued that we need to change the way we approach the regulation of financial institutions and look at what has been done in other sectors of the economy, where regulation and supervision are proactive and carefully implemented in order to guarantee the safety of society. The criterion for regulation and supervision should be neither Wall Street’s nor Main Street’s interests but rather the interests of the socioeconomic system. The latter requires financial stability if it’s to raise, durably, the standard of living of both Wall Street and Main Street. Systemic stability, not profits or homeownership, should be the paramount criterion for financial regulation, since systemic stability is required to maintain the profitability—and ultimately, the existence—of any capitalist economic entity. The role of the government is to continually counter the Ponzi tendencies of market mechanisms, even if they are (temporarily) improving standards of living, and to encourage economic agents to develop safe and reliable financial practices.

See also, Working Paper No. 573.1, “Securitization, Deregulation, Economic Stability, and Financial Crisis, Part I: The Evolution of Securitization.”

The Evolution of Securitization

This study analyzes the trends in the financial sector over the past 30 years, and argues that unsupervised financial innovations and lenient government regulation are at the root of the current financial crisis and recession. Combined with a long period of economic expansion during which default rates were stable and low, deregulation and unsupervised financial innovations generated incentives to make risky financial decisions. Those decisions were taken because it was the only way for financial institutions to maintain market share and profitability. Thus, rather than putting the blame on individuals, this paper places it on an economic setup that requires the growing use of Ponzi processes during enduring economic expansion, and on a regulatory system that is unwilling to recognize (on the contrary, it contributes to) the intrinsic instability of market mechanisms. Subprime lending, greed, and speculation are merely aspects of the larger mechanisms at work.

It is argued that we need to change the way we approach the regulation of financial institutions and look at what has been done in other sectors of the economy, where regulation and supervision are proactive and carefully implemented in order to guarantee the safety of society. The criterion for regulation and supervision should be neither Wall Street’s nor Main Street’s interests but rather the interests of the socioeconomic system. The latter requires financial stability if it’s to raise, durably, the standard of living of both Wall Street and Main Street. Systemic stability, not profits or homeownership, should be the paramount criterion for financial regulation, since systemic stability is required to maintain the profitability—and ultimately, the existence—of any capitalist economic entity. The role of the government is to continually counter the Ponzi tendencies of market mechanisms, even if they are (temporarily) improving standards of living, and to encourage economic agents to develop safe and reliable financial practices.

In 1930, John Maynard Keynes wrote: “The world has been slow to realise that we are living this year in the shadow of one of the greatest economic catastrophes of modern history.” The same holds true today: we are in the shadow of a global catastrophe, and we need to come to grips with the crisis—fast. According to Senior Scholar James K. Galbraith, two ingrained habits are leading to our failure to do so. The first is the assumption that economies will eventually return to normal on their own—an overly hopeful view that doesn’t take into account the massive pay-down of household debt resulting from the collapse of the banks. The second bad habit is the belief that recovery runs through the banks rather than around them. But credit cannot flow when there are no creditworthy borrowers or profitable projects; banks have failed, and the failure to recognize this is a recipe for wild speculation and control fraud, compounding taxpayer losses.

Galbraith outlines a number of measures that are needed now, including realistic economic forecasts, more honest bank auditing, effective financial regulation, measures to forestall evictions and keep people in their homes, and increased public retirement benefits. We are not in a temporary economic lull, an ordinary recession, from which we will emerge to return to business as usual, says Galbraith. Rather, we are at the beginning of a long, painful, profound, and irreversible process of change—we need to start thinking and acting accordingly.

Third Time a Charm? Or Strike Three?

United States financial regulation has traditionally made functional and institutional regulation roughly equivalent. However, the gradual shift away from Glass-Steagall and the introduction of the Financial Modernization Act (FMA) generated a disorderly mix of functions and products across institutions, creating regulatory gaps that contributed to the recent crisis. An analysis of this history suggests that a return to regulation by function or product would strengthen regulation. The FMA also made a choice in favor of financial holding companies over universal banks, but without recognizing that both types of structure require specific regulatory regimes. The paper reviews the specific regime that has been used by Germany in regulating its universal banks and suggests that a similar regime adapted to holding companies should be developed.